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Nifty and Sensex -- Poor options for index futures

Anup Menon

T. P. Madhusoodanan

IF THE plans of the two premier bourses work out, trading in derivative instruments may commence soon.

Both the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) have decided to introduce trading in stock index futures, the likely candidates being the BSE Sensitive Index (Sensex) and the S&P CNX Nifty.

But are these two indices the right ones for index futures? Not really. On the contrary, a derivatives instrument based on the S&P CNX Mid-Cap Index appears better suited, based on an empirical analysis of a representative sample of mutual fund portfolios and some randomly chosen ones. Should investor portfolios largely mimic mutual fund portfolios, the Sensex may turn out to be the worst choice for index futures.

But clearly, index futures is the way to go, as the market needs a tool for hedging that can be used by institutional and individual investors, as also, of course, speculators. While the futures market is likely to cater to the needs of mutual funds, institutional investors and high net worth investors, the impact will also be felt by the retail investors in a change in the volatility of the underlying index and its constituents.


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Futures, the way ahead

As of today, most international big names in the securities business have set up shop in the country, with most of them having a controlling interest in domestic mutual funds.

However, unlike other developed markets, the Indian market has so far not offered any tools to hedge risks. The badla system, an indigenous form of forward-trading, is prone to misuse and is not a hedging tool. Hence, the logical step is to introduce stock index futures.

Investors would look to `index futures' contract as a device for hedging their portfolios against losses. Alternatively, they would want to lock into a reasonable and acceptable rate of return. This is where index futures come in. The investors would have to enter into a contract for sale of `index futures' at the going value of the index. The idea being that even if the value of the index falls -- indicating a decline in the value of the portfolio -- that could be offset by a gain in the `futures' market.

After all, when you sell something for delivery at a future date, where the price agreed on is the current market price, any fall in the price of the asset on the delivery date actually represents a profit. So, the loss on current holdings of investment is offset by the gains in sale contract (futures) in a declining market.

But the effectiveness of this strategy -- that is, selling index futures -- lies in the investor portfolio reflecting the composition of the index itself. If not in terms of the actual identity, at least in terms of the relative value movements between the net asset values of the portfolios and the index being considered.


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Zeroing in on the index

With a variety of stock indices available, selecting the right one to introduce futures trading is important. This article presents the results of an empirical analysis of the hedging effectiveness of each of the indices, using simulated and mutual fund portfolios.

The test used to check for the best index is its hedging effectiveness with the portfolio. Hedging effectiveness refers to the gains in terms of reduction in the uncertainties associated with the profits a portfolio manager stands to gain by hedging risks.

For the analysis, six equity indices were chosen -- the BSE-Sensex, BSE-100 (Natex), BSE-200, S&P CNX Nifty, S&P CNX 500 and the Mid-Cap index. A test on the volatility of the indices showed that, over time, there was no abnormal volatility.

Testing with MF portfolios

The CNX Mid-Cap Index turns out to be the one with the highest hedging effectiveness, while the Sensex and Nifty are at the bottom. The average level of hedging effectiveness using the Mid-Cap index works out to 0.568, followed closely by the S&P CNX 500 with 0.486.

This means the fund manager using the CNX Mid-Cap Index to hedge his risks can minimise his variance in profits by around 60 per cent (0.568*100). In other words, 40 per cent of his portfolio variations would be exposed to the vagaries of the market movement. The Sensex and Nifty had a hedging effectiveness ratio of 0.12 and 0.34 respectively. Overall, the results show that the degree of hedge effectiveness is comparatively at the lower end.

Testing with simulated portfolios

In the absence of index futures, mutual fund schemes have been managed aggressively. This reduces the credibility of the results obtained from testing mutual fund portfolios. If the fund manager has the option of hedging his risks in the futures market, he may take a passive strategy with respect to his funds. Hence, it is necessary to test the efficiency of the indices using simulated portfolios which more or less mimic real portfolios but with the assumption that they are not shuffled frequently.

For this purpose, a test was run on the same set of indices with simulated portfolios. Close to 2,500 portfolios were generated from 312 stocks. Constraints were placed on the development of the portfolios to mimic mutual fund portfolios. The portfolio selections, as well as the weightages, were done randomly.

The results of the analysis were not surprising. The S&P CNX Mid-Cap Index turned out to be the best for hedging, with an effectiveness of 0.72, closely followed by the S&P CNX 500, with a ratio of 0.65. Sensex and Nifty were the worst performers, with effectiveness rates of 0.51 and 0.57 respectively.

Why is this so?

The basic reason, in this case, is the composition of the portfolio itself. Most of the portfolios analysed provided excess returns over their tenure. For instance, the Alliance '95 fund earned an excess return of close to 32.7 per cent over a balanced benchmark which constitutes 60 per cent of the BSE 200 index and 40 per cent debt.

These portfolios have a heavier weightage to the technology sector than some of the indices analysed. Hence, the movement in such benchmark indices as the Nifty and Sensex is not highly correlated with the net asset values of the portfolio. The other reason could be that as most of these schemes are actively managed, the portfolio shuffling might have led to the lower correlation with the indices. For instance, the Morgan Stanley Growth Fund where, in the top 25 exposures, there were seven new entrants in every quarter.

Consider this: The portfolios of Kothari Pioneer Prima, Kothari Pioneer Blue-chip, Morgan Stanley Growth Scheme, Alliance Tax Relief and Alliance '95 Dividend indicate a degree of correlation close to 90 per cent with the Mid-Cap Index. This literally means the portfolios of these funds more or less capture the trends in the Mid-Cap Index.

Some of the stocks in the Mid-Cap Index, such as Digital Equipment, Dr. Reddy's Laboratories, Software Solutions, Novartis, HCL Infosystems, Satyam Computers, Hero Honda and Zee Telefilms, are part of most of the portfolios considered. However, some of these stocks recently entered the Sensex and the Nifty.

Most market players do not closely follow the CNX Mid-Cap index. The possibility of introducing index futures on this index seems remote. But why have Sensex and Nifty, considered the market indices, failed? The main reason is that they have not been exposed to the technology sector for a significantly long period.

However, with the recent reshuffling of index constituents, there is more weightage on the technology sector. Hence, in the next couple of years, there may be better correlation between the main market indices and the mutual funds. Despite its low value in terms of hedging, the recent inclusion of some tech stocks in the indices may improve their value.

Desirable attributes for an index

Though Nifty and Sensex are not ideal for hedging, they have all the attributes required for introducing futures trading. Every index should have certain attributes to be used for futures trading. The most important issue in selecting an index is its liquidity. Illiquid indices have certain inherent problems that reduce the effectiveness of the products derived from them.

The important issue is that a highly liquid index is less prone to market manipulation than an illiquid one. Market manipulation refers to a few players moving the market to their convenience. Such markets fail to enthuse genuine investors, and this may result in the failure of the contracts.

The main problem with price manipulation is that it may lead to basis risk, which is the risk associated with the difference between the futures and the spot market. Consider this: If, on the arrival of significant information, the futures prices move in a way that reflects the available information, but the spot price does not move in tandem, some form of market manipulation may ensue. This tends to hamper the price discovery mechanism in an efficient market.

The index must be quoted on a real-time basis, as both the Nifty and the Sensex are. Further, there should be an opportunity for arbitrage between the spot and the futures markets. Index arbitrage bridges the gaps between the spot and futures markets, essentially leading to improved volumes in these markets.

(T. P. Madhusoodanan is on the faculty at the Institute for Financial Management and Research, Chennai.)


Section  : Opinion
Next     : Stock Index futures: A snapshot

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